Eq: Total Market
For most of this year and last, the idea of a nasty full-blown trade war was like a boogey man that stalked investors, but still seemed a slightly distant threat. That is no longer the case, as an ugly trade war has rapidly developed into the status quo. Accordingly, many top analysts, such as at JP Morgan and Nomura, are saying that high US tariffs on China are here to stay. Market volatility is likely to continue as new news continues to stream out.
FINSUM: There is a lot to worry about in this trade war, but one of our immediate, but less discussed, concerns is about the intersection of tariffs, the Fed, and inflation. The tariffs are likely to raise US inflation by boosting prices for goods, which could keep the Fed from hiking, trapping us in a difficult environment.
Bonds and stocks are at odds right now. Yields have dropped considerably as the bond market is predicting pain to come. Stocks have sold off, but are still around all-time highs. If you look at how money markets are currently priced they imply a whopping 20% decline in stocks. There is not a much macro data to support the money markets’ pricing, but it is certainly a sign to pay attention to. “The rates market has probably overreacted relative to other asset classes in the last two weeks. However, the macro backdrop is fundamentally more uncertain today”, says Deutsche Bank, continuing “The renewed trade tensions create downside risks which were deemed to be negligible 2 months ago”.
FINSUM: Stocks are going to react to economic data and the trade war, so the current forecasts for stock prices are only as good as one’s ability to prognosticate those factors.
There was a beautiful four-month window between December 2018 and May 2019 when everything looked positive. The trade spat with China looked increasingly mild and economic data was strong. It was a mirage. Even the hefty 3.2% GDP growth figure was mostly because of an incredible buildup in inventories, which when stripped away leave growth at 1.5%. Further, revised data shows that industrial production has dropped 1.2% since December. Even though this counts for a small portion of the economy, it is highly indicative of the business cycle. Some areas like auto production and machinery are down much more at 5%.
FINSUM: The glorious rally of the first third of the year seems to have stalled and the bad news is piling up, with the trade war exacerbating everything.
Whenever serious volatility strikes, investors get very nervous and don’t know how to react. One of the big questions is should I stay in the market? The other is which assets should I buy? Surprisingly, there is a fairly simple solution to handle volatility: every time the market moves wildly, hedge your portfolio with cash and/or options. When the markets calm down, unwind the hedge. Returns on stocks have actually been historically strongest during periods of low volatility (not the opposite).
FINSUM: The most interesting aspect here is that studies show that market returns have been highest in low volatility periods. Many people think that you have to stay in the market during volatile periods to make great returns, but that is simply not the case.
The trade war has far reaching consequences. One way to think about it, as bleak as it sounds, is that there is no winner whatsoever. However, there are sectors, ETFs, and stocks that will likely lose more than others. The technology, materials, and industrial sectors stand to lose the most in a prolonged trade war as they have the largest proportion of manufacturing in China and the highest proportion of Chinese customers. Boeing and Ingersoll-Rand, for instance, are both very exposed to China. However, the greatest pain is likely to be felt by technology companies in the iShares PHLX Semiconductor ETF like Qualcomm, Micron Technology, Broadcom, and Texas Instruments.
FINSUM: Basically anyone making or selling a large amount of products in China is in trouble. We also wonder about how increased tariffs would flow through to retailers who source a high percentage of their products in China (e.g. Walmart, Target etc.).
Economic data this year has mostly surprised to the upside. However, recently, things have started to disappoint. For instance, Citigroup’s basket of economic indicators has fallen to its lowest level since the Financial Crisis. Even the Atlanta Fed is bearish, recently forecasting GDP at 1.6%. Bond King Jeffrey Gundlach agrees, saying he believes the odds of a recession in the next 24 months are “very high”. He believes the chances of a recession within 12 months are 50-50.
FINSUM: We think Citi’s indicator is definitely overstating the situation. However, there are legitimate concerns about the economy, especially if you start to consider the possible implications of a trade war.